Using Contract Labor as a Tax Deductible Expense

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Contract labor is the use of independent contractors. From a tax perspective, the difference between contract labor (or an independent contractor) and an employee is like day and night. The IRS's general rule is that "an individual is an independent contractor if the payer has the right to control or direct only the result of the work and not what will be done and how it will be done."

A more workable definition of independent contractor status comes from common law principles which focus on the method of compensation. If an individual is on your payroll and receives a steady paycheck, clearly that the person is an employee rather than an independent contractor. Independent contractors usually operate under a specific contract and invoice for work completed. Other considerations that identify an individual as an independent contractor include:

  • If the worker supplies his or her own equipment, materials, and tools.
  • If all the necessary materials are not supplied by the employer.
  • If the worker can be discharged at any time and can choose whether or not to come to work without fear of losing employment.
  • If the worker controls the hours of employment. 
  • Whether the work is temporary or permanent.

Contract Labor and Your Small Business Taxes

The earnings of a person who is working as an independent contractor are subject to the self-employment tax. Independent contractors are self-employed, and therefore, they are not covered under most federal employment statutes. They are not protected from employment discrimination under Title VII, nor are they entitled to leave under the Family Medical Leave Act. You don't have to pay them benefits, Social Security, Medicare, workers' compensation or state unemployment taxes.

Wages paid to independent contractors can be deducted from your taxable income. For tax purposes, you must provide these individuals with the IRS form 1099-MISC and provide the IRS with Form 1096 to show how much you paid them. Of course, you should consult with your tax and accounting professionals to determine exactly what write-offs are legal and what procedures to follow and forms to use.

Tax Consequences If You Are a Contract Laborer

As an independent contractor, it's important that you pay estimated taxes, keep good records and know the deductions that may apply to you, which may include:

  • Home office deduction
  • Travel expenses, including your car
  • Health insurance premiums
  • Retirement account contributions
  • Depreciation of property and equipment
  • Educational expenses

Again, consult your tax and accounting professionals for guidance and compliance.

Closing Thoughts

Some companies opt to hire contractors instead of employees, in large part to save on the high cost of having them "on the books," which could easily inflate your payroll costs by 20 percent to 30 percent. Other advantages include the following:

  • You get the flexibility to expand or contract your workforce as needed. If you hire for a specific project, the expense is gone with the project is done. It's preordained so there's no trauma or legal trouble that can accompany letting someone go.
  • You get greater efficiency because many independent contracts bring specialized expertise, which also eliminates the time and cost of training.
  • You risk potentially fewer lawsuits as independent contractors are not protected by such state and federal laws like the right to the minimum wage or overtime, protection against certain discrimination, the right to form a union or take paid sick leave.

Some disadvantages include:

  • You get less control because independent contracts are just that: independent. Also, if you exercise too much control, the IRS may think they are really employees.
  • You have less stability in the workforce. These folks come and go, which also means less loyalty.
  • Your right to fire an independent contractor depends on your written agreement with them, or you're looking at a breach of contract.
  • You may be liable if they are hurt or injured on the job.
  • You may not own the copyright to the work or intellectual property that they create unless specified in your written agreement.
  • State and federal agencies want to see workers as employees because that means more tax revenue. You might be subject to an audit.